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Section 1: 10-Q (10-Q)

Document


 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q 
(Mark one)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended
March 31, 2018
or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from
 
to
 
           
Commission file number 1-14023 (Corporate Office Properties Trust)
Commission file number 333-189188 (Corporate Office Properties, L.P.)
Corporate Office Properties Trust
Corporate Office Properties, L.P.
(Exact name of registrant as specified in its charter)
Corporate Office Properties Trust
 
Maryland
 
23-2947217
 
 
(State or other jurisdiction of
 
(IRS Employer
 
 
incorporation or organization)
 
Identification No.)
 
 
 
 
 
Corporate Office Properties, L.P.
 
Delaware
 
23-2930022
 
 
(State or other jurisdiction of
 
(IRS Employer
 
 
incorporation or organization)
 
Identification No.)
6711 Columbia Gateway Drive, Suite 300, Columbia, MD
21046
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code:  (443) 285-5400
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Corporate Office Properties Trust ý Yes   o No
Corporate Office Properties, L.P. ý Yes   o No
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Corporate Office Properties Trust ý Yes   o No
Corporate Office Properties, L.P. ý Yes   o No





Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Corporate Office Properties Trust
Large accelerated filer ý
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company o
Emerging growth company o
 
 
 
 
(Do not check if a smaller reporting company)
 
 
 

Corporate Office Properties, L.P.
Large accelerated filer ý
 
Accelerated filer o
 
Non-accelerated filer o
 
Smaller reporting company o
Emerging growth company o
 
 
 
 
(Do not check if a smaller reporting company)
 
 
 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 

Corporate Office Properties Trust o
Corporate Office Properties, L.P. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)

Corporate Office Properties Trust o Yes   ý No
Corporate Office Properties, L.P. o Yes   ý No

As of April 20, 2018, 102,144,334 of Corporate Office Properties Trust’s Common Shares of Beneficial Interest, $0.01 par value, were issued and outstanding.
 
 
 
 
 

EXPLANATORY NOTE

This report combines the quarterly reports on Form 10-Q for the period ended March 31, 2018 of Corporate Office Properties Trust (“COPT”) and subsidiaries (collectively, the “Company”) and Corporate Office Properties, L.P. (“COPLP”) and subsidiaries (collectively, the “Operating Partnership”). Unless stated otherwise or the context otherwise requires, “we,” “our,” and “us” refer collectively to COPT, COPLP and their subsidiaries.

COPT is a real estate investment trust, or REIT, and the sole general partner of COPLP. As of March 31, 2018, COPT owned approximately 97.0% of the outstanding common units in COPLP; the remaining common units and all of the outstanding COPLP preferred units were owned by third parties. As the sole general partner of COPLP, COPT controls COPLP and can cause it to enter into major transactions including acquisitions, dispositions and refinancings and cause changes in its line of business, capital structure and distribution policies.

There are a few differences between the Company and the Operating Partnership which are reflected in this Form 10-Q. We believe it is important to understand the differences between the Company and the Operating Partnership in the context of how the two operate as an interrelated, consolidated company. COPT is a REIT whose only material asset is its ownership of partnership interests of COPLP. As a result, COPT does not conduct business itself, other than acting as the sole general partner of COPLP, issuing public equity and guaranteeing certain debt of COPLP. COPT itself is not directly obligated under any indebtedness but guarantees some of the debt of COPLP. COPLP owns substantially all of the assets of COPT either directly or through its subsidiaries, conducts almost all of the operations of the business and is structured as a limited partnership with no publicly traded equity. Except for net proceeds from public equity issuances by COPT, which are contributed to COPLP in exchange for partnership units, COPLP generates the capital required by COPT’s business through COPLP’s operations, by COPLP’s direct or indirect incurrence of indebtedness or through the issuance of partnership units.

Noncontrolling interests, shareholders’ equity and partners’ capital are the main areas of difference between the consolidated financial statements of COPT and those of COPLP. The common limited partnership interests in COPLP not owned by COPT are accounted for as partners’ capital in COPLP’s consolidated financial statements and as noncontrolling




interests in COPT’s consolidated financial statements. COPLP’s consolidated financial statements also reflect COPT’s noncontrolling interests in certain real estate partnerships and limited liability companies (“LLCs”); the differences between shareholders’ equity, partners’ capital and noncontrolling interests result from the differences in the equity issued at the COPT and COPLP levels and in COPT’s noncontrolling interests in these real estate partnerships and LLCs. The only other significant differences between the consolidated financial statements of COPT and those of COPLP are assets in connection with a non-qualified elective deferred compensation plan (comprised primarily of mutual funds and equity securities) and the corresponding liability to the plan’s participants that are held directly by COPT.

We believe combining the quarterly reports on Form 10-Q of the Company and the Operating Partnership into this single report results in the following benefits:
combined reports better reflect how management, investors and the analyst community view the business as a single operating unit;
combined reports enhance investors’ understanding of the Company and the Operating Partnership by enabling them to view the business as a whole and in the same manner as management;
combined reports are more efficient for the Company and the Operating Partnership and result in savings in time, effort and expense; and
combined reports are more efficient for investors by reducing duplicative disclosure and providing a single document for their review.

To help investors understand the significant differences between the Company and the Operating Partnership, this report presents the following separate sections for each of the Company and the Operating Partnership:
consolidated financial statements;
the following notes to the consolidated financial statements:
Note 4, Fair Value Measurements of COPT and subsidiaries and COPLP and subsidiaries; and
Note 15, Earnings per Share of COPT and subsidiaries and Earnings per Unit of COPLP and subsidiaries;
“Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources of COPT”; and
“Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources of COPLP.”

This report also includes separate sections under Part I, Item 4. Controls and Procedures and separate Exhibit 31 and Exhibit 32 certifications for each of COPT and COPLP to establish that the Chief Executive Officer and the Chief Financial Officer of each entity have made the requisite certifications and that COPT and COPLP are compliant with Rule 13a-15 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and 18 U.S.C. §1350.





TABLE OF CONTENTS
 
FORM 10-Q
 
 
PAGE
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2



PART I: FINANCIAL INFORMATION
ITEM 1. Financial Statements


Corporate Office Properties Trust and Subsidiaries
Consolidated Balance Sheets
(in thousands, except share data)
(unaudited)
 
March 31,
2018
 
December 31,
2017
Assets
 

 
 

Properties, net:
 

 
 

Operating properties, net
$
2,740,264

 
$
2,737,611

Projects in development or held for future development
418,015

 
403,494

Total properties, net
3,158,279

 
3,141,105

Assets held for sale, net
42,226

 
42,226

Cash and cash equivalents
8,888

 
12,261

Investment in unconsolidated real estate joint venture
41,311

 
41,787

Accounts receivable (net of allowance for doubtful accounts of $742 and $607, respectively)
23,982

 
31,802

Deferred rent receivable (net of allowance of $375 and $364, respectively)
87,985

 
86,710

Intangible assets on real estate acquisitions, net
54,600

 
59,092

Deferred leasing costs (net of accumulated amortization of $29,435 and $29,560, respectively)
47,886

 
48,322

Investing receivables
58,800

 
57,493

Prepaid expenses and other assets, net
72,281

 
74,407

Total assets
$
3,596,238

 
$
3,595,205

Liabilities and equity
 

 
 

Liabilities:
 

 
 

Debt, net
$
1,854,886

 
$
1,828,333

Accounts payable and accrued expenses
95,721

 
108,137

Rents received in advance and security deposits
26,569

 
25,648

Dividends and distributions payable
29,146

 
28,921

Deferred revenue associated with operating leases
11,246

 
11,682

Deferred property sale
43,377

 
43,377

Capital lease obligation
11,778

 
15,853

Other liabilities
17,643

 
41,822

Total liabilities
2,090,366

 
2,103,773

Commitments and contingencies (Note 16)


 


Redeemable noncontrolling interests
23,848

 
23,125

Equity:
 

 
 

Corporate Office Properties Trust’s shareholders’ equity:
 

 
 

Common Shares of beneficial interest ($0.01 par value; 150,000,000 shares authorized; shares issued and outstanding of 102,150,358 at March 31, 2018 and 101,292,299 at December 31, 2017)
1,022

 
1,013

Additional paid-in capital
2,221,427

 
2,201,047

Cumulative distributions in excess of net income
(813,302
)
 
(802,085
)
Accumulated other comprehensive income
7,204

 
2,167

Total Corporate Office Properties Trust’s shareholders’ equity
1,416,351

 
1,402,142

Noncontrolling interests in subsidiaries:
 

 
 

Common units in COPLP
44,327

 
45,097

Preferred units in COPLP
8,800

 
8,800

Other consolidated entities
12,546

 
12,268

Noncontrolling interests in subsidiaries
65,673

 
66,165

Total equity
1,482,024

 
1,468,307

Total liabilities, redeemable noncontrolling interests and equity
$
3,596,238

 
$
3,595,205

See accompanying notes to consolidated financial statements.

3



Corporate Office Properties Trust and Subsidiaries
Consolidated Statements of Operations
(in thousands, except per share data)
(unaudited)
 
For the Three Months Ended March 31,
 
2018
 
2017
Revenues
 

 
 

Rental revenue
$
100,834

 
$
100,615

Tenant recoveries and other real estate operations revenue
27,444

 
26,152

Construction contract and other service revenues
27,198

 
13,034

Total revenues
155,476

 
139,801

Expenses
 

 
 

Property operating expenses
50,951

 
48,519

Depreciation and amortization associated with real estate operations
33,512

 
33,059

Construction contract and other service expenses
26,216

 
12,486

General, administrative and leasing expenses
7,292

 
8,611

Business development expenses and land carry costs
1,614

 
1,693

Total operating expenses
119,585

 
104,368

Operating income
35,891

 
35,433

Interest expense
(18,784
)
 
(18,994
)
Interest and other income
1,359

 
1,726

Income before equity in income of unconsolidated entities and income taxes
18,466

 
18,165

Equity in income of unconsolidated entities
373

 
377

Income tax expense
(55
)
 
(40
)
Income before gain on sales of real estate
18,784

 
18,502

Gain on sales of real estate
(4
)
 
4,238

Net income
18,780

 
22,740

Net income attributable to noncontrolling interests:
 

 
 

Common units in COPLP
(544
)
 
(622
)
Preferred units in COPLP
(165
)
 
(165
)
Other consolidated entities
(921
)
 
(934
)
Net income attributable to COPT
17,150

 
21,019

Preferred share dividends

 
(3,180
)
Net income attributable to COPT common shareholders
$
17,150

 
$
17,839

Earnings per common share:
 

 
 

Net income attributable to COPT common shareholders - basic
$
0.17

 
$
0.18

Net income attributable to COPT common shareholders - diluted
$
0.17

 
$
0.18

Dividends declared per common share
$
0.275

 
$
0.275


See accompanying notes to consolidated financial statements.

4



Corporate Office Properties Trust and Subsidiaries
Consolidated Statements of Comprehensive Income
(in thousands)
(unaudited)
 
 
For the Three Months Ended March 31,
 
2018
 
2017
Net income
$
18,780

 
$
22,740

Other comprehensive income
 

 
 

Unrealized gain on interest rate derivatives
4,676

 
224

Loss on interest rate derivatives recognized in interest expense
245

 
1,184

Other comprehensive income
4,921

 
1,408

Comprehensive income
23,701

 
24,148

Comprehensive income attributable to noncontrolling interests
(1,790
)
 
(1,768
)
Comprehensive income attributable to COPT
$
21,911

 
$
22,380

 
See accompanying notes to consolidated financial statements.



5



Corporate Office Properties Trust and Subsidiaries
Consolidated Statements of Equity
(Dollars in thousands)
(unaudited)
 
Preferred
Shares
 
Common
Shares
 
Additional
Paid-in
Capital
 
Cumulative
Distributions in
Excess of Net
Income
 
Accumulated
Other
Comprehensive Income (Loss)
 
Noncontrolling
Interests
 
Total
Balance at December 31, 2016 (98,498,651 common shares outstanding)
$
172,500

 
$
985

 
$
2,116,581

 
$
(747,825
)
 
$
(1,731
)
 
$
72,267

 
$
1,612,777

Conversion of common units to common shares (185,000 shares)

 
2

 
2,535

 

 

 
(2,537
)
 

Common shares issued under at-the-market program (546,782 shares)

 
5

 
18,217

 

 

 

 
18,222

Share-based compensation (159,801 shares issued, net of redemptions)

 
2

 
1,580

 

 

 

 
1,582

Redemption of vested equity awards

 

 
(1,753
)
 

 

 

 
(1,753
)
Adjustments to noncontrolling interests resulting from changes in ownership of COPLP

 

 
(246
)
 

 

 
246

 

Comprehensive income

 

 

 
21,019

 
1,361

 
1,201

 
23,581

Dividends

 

 

 
(30,524
)
 

 

 
(30,524
)
Distributions to owners of common and preferred units in COPLP

 

 

 

 

 
(1,101
)
 
(1,101
)
Distributions to noncontrolling interests in other consolidated entities

 

 

 

 

 
(2,606
)
 
(2,606
)
Adjustment to arrive at fair value of redeemable noncontrolling interests

 

 
(545
)
 

 

 

 
(545
)
Balance at March 31, 2017 (99,390,234 common shares outstanding)
$
172,500

 
$
994

 
$
2,136,369

 
$
(757,330
)
 
$
(370
)
 
$
67,470

 
$
1,619,633

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017 (101,292,299 common shares outstanding)
$

 
$
1,013

 
$
2,201,047

 
$
(802,085
)
 
$
2,167

 
$
66,165

 
$
1,468,307

Cumulative effect of accounting change for adoption of hedge accounting guidance

 

 

 
(276
)
 
276

 

 

Balance at December 31, 2017, as adjusted

 
1,013

 
2,201,047

 
(802,361
)
 
2,443

 
66,165

 
1,468,307

Conversion of common units to common shares (53,817 shares)

 
1

 
760

 

 

 
(761
)
 

Common shares issued under forward equity sale agreements (677,000 shares)

 
7

 
19,969

 

 

 

 
19,976

Share-based compensation (127,242 shares issued, net of redemptions)

 
1

 
1,679

 

 

 

 
1,680

Redemption of vested equity awards

 

 
(1,327
)
 

 

 

 
(1,327
)
Adjustments to noncontrolling interests resulting from changes in ownership of COPLP

 

 
(164
)
 

 

 
164

 

Comprehensive income

 

 

 
17,150

 
4,761

 
1,152

 
23,063

Dividends

 

 

 
(28,091
)
 

 

 
(28,091
)
Distributions to owners of common and preferred units in COPLP

 

 

 

 

 
(1,044
)
 
(1,044
)
Distributions to noncontrolling interests in other consolidated entities

 

 

 

 

 
(3
)
 
(3
)
Adjustment to arrive at fair value of redeemable noncontrolling interests

 

 
(537
)
 

 

 

 
(537
)
Balance at March 31, 2018 (102,150,358 common shares outstanding)
$

 
$
1,022

 
$
2,221,427

 
$
(813,302
)
 
$
7,204

 
$
65,673

 
$
1,482,024


See accompanying notes to consolidated financial statements.

6



Corporate Office Properties Trust and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)
(unaudited) 
 
For the Three Months Ended March 31,
 
2018
 
2017
Cash flows from operating activities
 

 
 

Revenues from real estate operations received
$
135,027

 
$
132,985

Construction contract and other service revenues received
9,268

 
23,527

Property operating expenses paid
(43,212
)
 
(40,837
)
Construction contract and other service expenses paid
(41,128
)
 
(14,790
)
General, administrative, leasing, business development and land carry costs paid
(10,900
)
 
(14,275
)
Interest expense paid
(19,092
)
 
(19,549
)
Lease incentives paid
(4,204
)
 
(7,729
)
Other
436

 
750

Net cash provided by operating activities
26,195

 
60,082

Cash flows from investing activities
 

 
 

Construction, development and redevelopment
(17,540
)
 
(35,795
)
Tenant improvements on operating properties
(9,077
)
 
(6,916
)
Other capital improvements on operating properties
(5,198
)
 
(5,203
)
Proceeds from dispositions of properties

 
52,596

Leasing costs paid
(2,015
)
 
(2,042
)
Other
(974
)
 
(630
)
Net cash (used in) provided by investing activities
(34,804
)
 
2,010

Cash flows from financing activities
 

 
 

Proceeds from debt
 
 
 
Revolving Credit Facility
82,000

 

Repayments of debt
 
 
 
Revolving Credit Facility
(55,000
)
 

Scheduled principal amortization
(1,052
)
 
(1,008
)
Payments on capital lease obligation
(4,202
)
 

Net proceeds from issuance of common shares
19,989

 
18,237

Redemption of preferred shares

 
(26,583
)
Common share dividends paid
(27,855
)
 
(27,100
)
Preferred share dividends paid

 
(3,581
)
Distributions paid to noncontrolling interests in COPLP
(1,059
)
 
(1,156
)
Redemption of vested equity awards
(1,327
)
 
(1,753
)
Other
(5,183
)
 
(3,009
)
Net cash provided by (used in) financing activities
6,311

 
(45,953
)
Net (decrease) increase in cash and cash equivalents and restricted cash
(2,298
)
 
16,139

Cash and cash equivalents and restricted cash
 

 
 

Beginning of period
14,831

 
212,619

End of period
$
12,533

 
$
228,758


See accompanying notes to consolidated financial statements.
 


7



Corporate Office Properties Trust and Subsidiaries
Consolidated Statements of Cash Flows (continued)
(in thousands)
(unaudited)
 
For the Three Months Ended March 31,
 
2018
 
2017
Reconciliation of net income to net cash provided by operating activities:
 

 
 

Net income
$
18,780

 
$
22,740

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation and amortization
34,035

 
33,570

Amortization of deferred financing costs and net debt discounts
822

 
1,348

Increase in deferred rent receivable
(1,512
)
 
(191
)
Gain on sales of real estate
4

 
(4,238
)
Share-based compensation
1,545

 
1,488

Other
(907
)
 
(1,447
)
Changes in operating assets and liabilities:
 

 
 
Decrease in accounts receivable
7,877

 
5,007

Decrease in prepaid expenses and other assets, net
8,533

 
15,479

Decrease in accounts payable, accrued expenses and other liabilities
(43,903
)
 
(12,269
)
Increase (decrease) in rents received in advance and security deposits
921

 
(1,405
)
Net cash provided by operating activities
$
26,195

 
$
60,082

Reconciliation of cash and cash equivalents and restricted cash:
 
 
 
Cash and cash equivalents at beginning of period
$
12,261

 
$
209,863

Restricted cash at beginning of period
2,570

 
2,756

Cash and cash equivalents and restricted cash at beginning of period
$
14,831

 
$
212,619

 
 
 
 
Cash and cash equivalents at end of period
$
8,888

 
$
226,470

Restricted cash at end of period
3,645

 
2,288

Cash and cash equivalents and restricted cash at end of period
$
12,533

 
$
228,758

Supplemental schedule of non-cash investing and financing activities:
 

 
 

Increase (decrease) in accrued capital improvements, leasing and other investing activity costs
$
12,232

 
$
(6,661
)
Increase in fair value of derivatives applied to accumulated other comprehensive income and noncontrolling interests
$
4,887

 
$
1,408

Dividends/distributions payable
$
29,146

 
$
31,131

Decrease in noncontrolling interests and increase in shareholders’ equity in connection with the conversion of common units into common shares
$
761

 
$
2,537

Adjustments to noncontrolling interests resulting from changes in COPLP ownership
$
164

 
$
246

Increase in redeemable noncontrolling interests and decrease in equity to carry redeemable noncontrolling interests at fair value
$
537

 
$
545

 
See accompanying notes to consolidated financial statements.


8





Corporate Office Properties, L.P. and Subsidiaries
Consolidated Balance Sheets
(in thousands, except unit data)
(unaudited)
 
March 31,
2018
 
December 31,
2017
Assets
 

 
 

Properties, net:
 

 
 

Operating properties, net
$
2,740,264

 
$
2,737,611

Projects in development or held for future development
418,015

 
403,494

Total properties, net
3,158,279

 
3,141,105

Assets held for sale, net
42,226

 
42,226

Cash and cash equivalents
8,888

 
12,261

Investment in unconsolidated real estate joint venture
41,311

 
41,787

Accounts receivable (net of allowance for doubtful accounts of $742 and $607, respectively)
23,982

 
31,802

Deferred rent receivable (net of allowance of $375 and $364, respectively)
87,985

 
86,710

Intangible assets on real estate acquisitions, net
54,600

 
59,092

Deferred leasing costs (net of accumulated amortization of $29,435 and $29,560, respectively)
47,886

 
48,322

Investing receivables
58,800

 
57,493

Prepaid expenses and other assets, net
67,800

 
69,791

Total assets
$
3,591,757

 
$
3,590,589

Liabilities and equity
 

 
 

Liabilities:
 

 
 

Debt, net
$
1,854,886

 
$
1,828,333

Accounts payable and accrued expenses
95,721

 
108,137

Rents received in advance and security deposits
26,569

 
25,648

Distributions payable
29,146

 
28,921

Deferred revenue associated with operating leases
11,246

 
11,682

Deferred property sale
43,377

 
43,377

Capital lease obligation
11,778


15,853

Other liabilities
13,162

 
37,206

Total liabilities
2,085,885

 
2,099,157

Commitments and contingencies (Note 16)


 


Redeemable noncontrolling interests
23,848

 
23,125

Equity:
 

 
 

Corporate Office Properties, L.P.’s equity:
 

 
 

Preferred units held by limited partner, 352,000 preferred units outstanding at March 31, 2018 and December 31, 2017
8,800

 
8,800

Common units, 102,150,358 and 101,292,299 held by the general partner and 3,197,061 and 3,250,878 held by limited partners at March 31, 2018 and December 31, 2017, respectively
1,453,262

 
1,445,022

Accumulated other comprehensive income
7,370

 
2,173

Total Corporate Office Properties, L.P.’s equity
1,469,432

 
1,455,995

Noncontrolling interests in subsidiaries
12,592

 
12,312

Total equity
1,482,024

 
1,468,307

Total liabilities, redeemable noncontrolling interests and equity
$
3,591,757

 
$
3,590,589


See accompanying notes to consolidated financial statements.


9



Corporate Office Properties, L.P. and Subsidiaries
Consolidated Statements of Operations
(in thousands, except per unit data)
(unaudited)
 
For the Three Months Ended March 31,
 
2018
 
2017
Revenues
 

 
 

Rental revenue
$
100,834

 
$
100,615

Tenant recoveries and other real estate operations revenue
27,444

 
26,152

Construction contract and other service revenues
27,198

 
13,034

Total revenues
155,476

 
139,801

Expenses
 

 
 

Property operating expenses
50,951

 
48,519

Depreciation and amortization associated with real estate operations
33,512

 
33,059

Construction contract and other service expenses
26,216

 
12,486

General, administrative and leasing expenses
7,292

 
8,611

Business development expenses and land carry costs
1,614

 
1,693

Total operating expenses
119,585

 
104,368

Operating income
35,891

 
35,433

Interest expense
(18,784
)
 
(18,994
)
Interest and other income
1,359

 
1,726

Income before equity in income of unconsolidated entities and income taxes
18,466

 
18,165

Equity in income of unconsolidated entities
373

 
377

Income tax expense
(55
)
 
(40
)
Income before gain on sales of real estate
18,784

 
18,502

Gain on sales of real estate
(4
)
 
4,238

Net income
18,780

 
22,740

Net income attributable to noncontrolling interests in consolidated entities
(921
)
 
(934
)
Net income attributable to COPLP
17,859

 
21,806

Preferred unit distributions
(165
)
 
(3,345
)
Net income attributable to COPLP common unitholders
$
17,694

 
$
18,461

Earnings per common unit:
 

 
 

Net income attributable to COPLP common unitholders - basic
$
0.17

 
$
0.18

Net income attributable to COPLP common unitholders - diluted
$
0.17

 
$
0.18

Distributions declared per common unit
$
0.275

 
$
0.275


See accompanying notes to consolidated financial statements.

10



Corporate Office Properties, L.P. and Subsidiaries
Consolidated Statements of Comprehensive Income
(in thousands)
(unaudited) 
 
For the Three Months Ended March 31,
 
2018
 
2017
Net income
$
18,780

 
$
22,740

Other comprehensive income
 

 
 

Unrealized gain on interest rate derivatives
4,676

 
224

Loss on interest rate derivatives recognized in interest expense
245

 
1,184

Other comprehensive income
4,921

 
1,408

Comprehensive income
23,701

 
24,148

Comprehensive income attributable to noncontrolling interests
(921
)
 
(934
)
Comprehensive income attributable to COPLP
$
22,780

 
$
23,214

 
See accompanying notes to consolidated financial statements.



11



Corporate Office Properties, L.P. and Subsidiaries
Consolidated Statements of Equity
(Dollars in thousands)
(unaudited)
 
Limited Partner Preferred Units
 
General Partner
 Preferred Units
 
Common Units
 
Accumulated Other Comprehensive Income (Loss)
 
Noncontrolling Interests in Subsidiaries
 
 
 
Units
 
Amount
 
Units
 
Amount
 
Units
 
Amount
 
 
 
Total Equity
Balance at December 31, 2016
352,000

 
$
8,800

 
6,900,000

 
$
172,500

 
102,089,042

 
$
1,419,710

 
$
(1,854
)
 
$
13,621

 
$
1,612,777

Issuance of common units resulting from common shares issued under COPT at-the-market program

 

 

 

 
546,782

 
18,222

 

 

 
18,222

Share-based compensation (units net of redemption)

 

 

 

 
159,801

 
1,582

 

 

 
1,582

Redemptions of vested equity awards

 

 

 

 

 
(1,753
)
 

 

 
(1,753
)
Comprehensive income

 
165

 

 
3,180

 

 
18,461

 
1,408

 
367

 
23,581

Distributions to owners of common and preferred units

 
(165
)
 

 
(3,180
)
 

 
(28,280
)
 

 

 
(31,625
)
Distributions to noncontrolling interests in subsidiaries

 

 

 

 

 

 

 
(2,606
)
 
(2,606
)
Adjustment to arrive at fair value of redeemable noncontrolling interests

 

 

 

 

 
(545
)
 

 

 
(545
)
Balance at March 31, 2017
352,000

 
$
8,800

 
6,900,000

 
$
172,500

 
102,795,625

 
$
1,427,397

 
$
(446
)
 
$
11,382

 
$
1,619,633

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2017
352,000

 
$
8,800

 

 
$

 
104,543,177

 
$
1,445,022

 
$
2,173

 
$
12,312

 
$
1,468,307

Cumulative effect of accounting change for adoption of hedge accounting guidance

 

 

 

 

 
(276
)
 
276

 

 

Balance at December 31, 2017, as adjusted
352,000

 
8,800

 

 

 
104,543,177

 
1,444,746

 
2,449

 
12,312

 
1,468,307

Issuance of common units resulting from common shares issued under COPT forward equity sale agreements

 

 

 

 
677,000

 
19,976

 

 

 
19,976

Share-based compensation (units net of redemption)

 

 

 

 
127,242

 
1,680

 

 

 
1,680

Redemptions of vested equity awards

 

 

 

 

 
(1,327
)
 

 

 
(1,327
)
Comprehensive income

 
165

 

 

 

 
17,694

 
4,921

 
283

 
23,063

Distributions to owners of common and preferred units

 
(165
)
 

 

 

 
(28,970
)
 

 

 
(29,135
)
Distributions to noncontrolling interests in subsidiaries

 

 

 

 

 

 

 
(3
)
 
(3
)
Adjustment to arrive at fair value of redeemable noncontrolling interests

 

 

 

 

 
(537
)
 

 

 
(537
)
Balance at March 31, 2018
352,000

 
$
8,800

 

 
$

 
105,347,419

 
$
1,453,262

 
$
7,370

 
$
12,592

 
$
1,482,024


See accompanying notes to consolidated financial statements.

12



Corporate Office Properties, L.P. and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
 
For the Three Months Ended March 31,
 
2018
 
2017
Cash flows from operating activities
 

 
 

Revenues from real estate operations received
$
135,027

 
$
132,985

Construction contract and other service revenues received
9,268

 
23,527

Property operating expenses paid
(43,212
)
 
(40,837
)
Construction contract and other service expenses paid
(41,128
)
 
(14,790
)
General, administrative, leasing, business development and land carry costs paid
(10,900
)
 
(14,275
)
Interest expense paid
(19,092
)
 
(19,549
)
Lease incentives paid
(4,204
)
 
(7,729
)
Other
436

 
750

Net cash provided by operating activities
26,195

 
60,082

Cash flows from investing activities
 

 
 

Construction, development and redevelopment
(17,540
)
 
(35,795
)
Tenant improvements on operating properties
(9,077
)
 
(6,916
)
Other capital improvements on operating properties
(5,198
)
 
(5,203
)
Proceeds from dispositions of properties

 
52,596

Leasing costs paid
(2,015
)
 
(2,042
)
Other
(974
)
 
(630
)
Net cash (used in) provided by investing activities
(34,804
)
 
2,010

Cash flows from financing activities
 

 
 

Proceeds from debt
 
 
 
Revolving Credit Facility
82,000

 

Repayments of debt
 
 
 
Revolving Credit Facility
(55,000
)
 

Scheduled principal amortization
(1,052
)
 
(1,008
)
Payments on capital lease obligation
(4,202
)
 

Net proceeds from issuance of common units
19,989

 
18,237

Redemption of preferred units

 
(26,583
)
Common unit distributions paid
(28,749
)
 
(28,091
)
Preferred unit distributions paid
(165
)
 
(3,746
)
Redemption of vested equity awards
(1,327
)
 
(1,753
)
Other
(5,183
)
 
(3,009
)
Net cash provided by (used in) financing activities
6,311

 
(45,953
)
Net (decrease) increase in cash and cash equivalents and restricted cash
(2,298
)
 
16,139

Cash and cash equivalents and restricted cash
 

 
 

Beginning of period
14,831

 
212,619

End of period
$
12,533

 
$
228,758


See accompanying notes to consolidated financial statements.

13



Corporate Office Properties, L.P. and Subsidiaries
Consolidated Statements of Cash Flows (Continued)
(in thousands)
(unaudited)

 
For the Three Months Ended March 31,
 
2018
 
2017
Reconciliation of net income to net cash provided by operating activities:
 

 
 

Net income
$
18,780

 
$
22,740

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Depreciation and amortization
34,035

 
33,570

Amortization of deferred financing costs and net debt discounts
822

 
1,348

Increase in deferred rent receivable
(1,512
)
 
(191
)
Gain on sales of real estate
4

 
(4,238
)
Share-based compensation
1,545

 
1,488

Other
(907
)
 
(1,447
)
Operating changes in assets and liabilities:
 

 
 
Decrease in accounts receivable
7,877

 
5,007

Decrease in prepaid expenses and other assets, net
8,398

 
14,193

Decrease in accounts payable, accrued expenses and other liabilities
(43,768
)
 
(10,983
)
Increase (decrease) in rents received in advance and security deposits
921

 
(1,405
)
Net cash provided by operating activities
$
26,195

 
$
60,082

Reconciliation of cash and cash equivalents and restricted cash:
 
 
 
Cash and cash equivalents at beginning of period
$
12,261

 
$
209,863

Restricted cash at beginning of period
2,570

 
2,756

Cash and cash equivalents and restricted cash at beginning of period
$
14,831

 
$
212,619

 
 
 
 
Cash and cash equivalents at end of period
$
8,888

 
$
226,470

Restricted cash at end of period
3,645

 
2,288

Cash and cash equivalents and restricted cash at end of period
$
12,533

 
$
228,758

Supplemental schedule of non-cash investing and financing activities:
 

 
 

Increase (decrease) in accrued capital improvements, leasing and other investing activity costs
$
12,232

 
$
(6,661
)
Increase in fair value of derivatives applied to accumulated other comprehensive income and noncontrolling interests
$
4,887

 
$
1,408

Distributions payable
$
29,146

 
$
31,131

Increase in redeemable noncontrolling interests and decrease in equity to carry redeemable noncontrolling interests at fair value
$
537

 
$
545

 
See accompanying notes to consolidated financial statements.



14



Corporate Office Properties Trust and Subsidiaries and Corporate Office Properties, L.P. and Subsidiaries
Notes to Consolidated Financial Statements
(unaudited)
 
1.    Organization
 
Corporate Office Properties Trust (“COPT”) and subsidiaries (collectively, the “Company”) is a fully-integrated and self-managed real estate investment trust (“REIT”). Corporate Office Properties, L.P. (“COPLP”) and subsidiaries (collectively, the “Operating Partnership”) is the entity through which COPT, the sole general partner of COPLP, conducts almost all of its operations and owns almost all of its assets. Unless otherwise expressly stated or the context otherwise requires, “we”, “us” and “our” as used herein refer to each of the Company and the Operating Partnership. We own, manage, lease, develop and selectively acquire office and data center properties. The majority of our portfolio is in locations that support the United States Government and its contractors, most of whom are engaged in national security, defense and information technology (“IT”) related activities servicing what we believe are growing, durable, priority missions (“Defense/IT Locations”). We also own a portfolio of office properties located in select urban/urban-like submarkets in the Greater Washington, DC/Baltimore region
with durable Class-A office fundamentals and characteristics (“Regional Office”). As of March 31, 2018, our properties included the following:

159 properties totaling 17.6 million square feet comprised of 144 office properties and 15 single-tenant data center shell properties (“data center shells”). We owned six of these data center shells through an unconsolidated real estate joint venture;
a wholesale data center with a critical load of 19.25 megawatts;
seven properties under construction or redevelopment (four office properties and three data center shells) that we estimate will total approximately 619,000 square feet upon completion, including one partially-operational property; and
approximately 1,000 acres of land controlled for future development that we believe could be developed into approximately 13.0 million square feet and 150 acres of other land.
 
COPLP owns real estate directly and through subsidiary partnerships and limited liability companies (“LLCs”).  In addition to owning real estate, COPLP also owns subsidiaries that provide real estate services such as property management and construction and development services primarily for our properties but also for third parties. Some of these services are performed by a taxable REIT subsidiary (“TRS”).

Equity interests in COPLP are in the form of common and preferred units. As of March 31, 2018, COPT owned 97.0% of the outstanding COPLP common units (“common units”); the remaining common units and all of the outstanding COPLP preferred units (“preferred units”) were owned by third parties. Common units not owned by COPT carry certain redemption rights. The number of common units owned by COPT is equivalent to the number of outstanding common shares of beneficial interest (“common shares”) of COPT, and the entitlement of all common units to quarterly distributions and payments in liquidation is substantially the same as those of COPT common shareholders. Similarly, in the case of any series of preferred units held by COPT, there is a series of preferred shares of beneficial interest (“preferred shares”) in COPT that is equivalent in number and carries substantially the same terms as such series of COPLP preferred units. COPT’s common shares are publicly traded on the New York Stock Exchange (“NYSE”) under the ticker symbol “OFC”.

Because COPLP is managed by COPT, and COPT conducts substantially all of its operations through COPLP, we refer to COPT’s executive officers as COPLP’s executive officers; similarly, although COPLP does not have a board of trustees, we refer to COPT’s Board of Trustees as COPLP’s Board of Trustees.
  
2.     Summary of Significant Accounting Policies
 
Basis of Presentation
 
The COPT consolidated financial statements include the accounts of COPT, the Operating Partnership, their subsidiaries and other entities in which COPT has a majority voting interest and control.  The COPLP consolidated financial statements include the accounts of COPLP, its subsidiaries and other entities in which COPLP has a majority voting interest and control.  We also consolidate certain entities when control of such entities can be achieved through means other than voting rights (“variable interest entities” or “VIEs”) if we are deemed to be the primary beneficiary of such entities.  We eliminate all intercompany balances and transactions in consolidation.

15




 We use the equity method of accounting when we own an interest in an entity and can exert significant influence over but cannot control the entity’s operations. We discontinue equity method accounting if our investment in an entity (and net advances) is reduced to zero unless we have guaranteed obligations of the entity or are otherwise committed to provide further financial support for the entity.
 
We use the cost method of accounting when we own an interest in an entity and cannot exert significant influence over its operations.

These interim financial statements should be read together with the consolidated financial statements and notes thereto as of and for the year ended December 31, 2017 included in our 2017 Annual Report on Form 10-K.  The unaudited consolidated financial statements include all adjustments that are necessary, in the opinion of management, to fairly state our financial position and results of operations.  All adjustments are of a normal recurring nature.  The consolidated financial statements have been prepared using the accounting policies described in our 2017 Annual Report on Form 10-K as updated for our adoption of recent accounting pronouncements discussed below.

Reclassification

We reclassified certain amounts from prior periods to conform to the current period presentation of our consolidated financial statements with no effect on previously reported net income or equity, including restricted cash and marketable securities that were reclassified to the line entitled “prepaid expenses and other assets, net” on our consolidated balance sheets after having been reported on a separate line in our previous Quarterly Reports on Form 10-Q and Annual Reports on Form 10-K.

Recent Accounting Pronouncements

We adopted guidance issued by the Financial Accounting Standards Board (“FASB”) effective January 1, 2018 regarding the recognition of revenue from contracts with customers (“Topic 606”). Under this guidance, an entity recognizes revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This guidance also requires improved disclosures regarding the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. We determined that Topic 606 is applicable to our construction contract and other service revenues, which includes predominantly construction and design projects performed primarily for tenants of our properties. We used the modified retrospective method for contracts that were not completed as of January 1, 2018. Under this method, the cumulative effect of initially applying the guidance is recognized as an adjustment to the opening balance of retained earnings as of the date of initial application. Our adoption of Topic 606 effective January 1, 2018 did not affect our consolidated financial statements other than additional disclosure provided in accordance with the guidance. We did not elect to use any of the practical expedients provided for under the guidance. As discussed further below, once the new guidance setting forth principles for the recognition, measurement, presentation and disclosure of leases goes into effect on January 1, 2019, Topic 606 may apply to executory costs and other components of revenue due under leases that are deemed to be non-lease components (such as common area maintenance and provision of utilities).

We adopted guidance issued by the FASB effective January 1, 2018 that requires entities to measure equity investments at fair value through net income, except for those that result in consolidation or are accounted for under the equity method of accounting. For equity investments without readily determinable fair values, the guidance permits the application of a measurement alternative using the cost of the investment, less any impairments, plus or minus changes resulting from observable price changes for an identical or similar investment of the same issuer. Our adoption of this guidance had no effect on our consolidated financial statements.
 
We adopted guidance issued by the FASB retrospectively effective January 1, 2018 that clarifies how entities should classify certain cash receipts and cash payments on the statement of cash flows with the objective of reducing the existing diversity in practice related to eight specific cash flow issues. The areas addressed in the new guidance relate to debt prepayment costs, settlement of zero-coupon debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned and bank-owned life insurance policies, distributions received from equity method investments, beneficial interest in securitization transactions and separately identifiable cash flows and application of the predominance principle. Our adoption of this guidance had no effect on our consolidated financial statements.


16



We adopted guidance issued by the FASB retrospectively effective January 1, 2018 that requires the statement of cash flows to explain the change during the period in the total of cash, cash equivalents and amounts described as restricted cash or restricted cash equivalents.  Under the new guidance, amounts described as restricted cash and restricted cash equivalents will be included with cash and cash equivalents when reconciling the beginning of period and end of period total amounts shown on the statement of cash flows.  As a result of our adoption of this guidance, the change in restricted cash is no longer reported as either operating or investing activities on our statements of cash flows. Our restricted cash primarily consists of cash escrowed under mortgage debt for capital improvements and real estate taxes and certain tenant security deposits. Our adoption of this guidance had the following effects on our consolidated statements of cash flows for the three months ended March 31, 2017 (in thousands):
 
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
Net cash provided by operating activities
 
$
60,637

 
$
(555
)
 
$
60,082

Net cash provided by investing activities
 
$
1,923

 
$
87

 
$
2,010

Net increase in cash and cash equivalents and restricted cash
 
$
16,607

 
$
(468
)
 
$
16,139

Beginning of period cash and cash equivalents and restricted cash
 
$
209,863

 
$
2,756

 
$
212,619

End of period cash and cash equivalents and restricted cash
 
$
226,470

 
$
2,288

 
$
228,758


We adopted guidance issued by the FASB that clarifies the scope of provisions and accounting for nonfinancial asset derecognition, including partial sales of real estate assets, effective January 1, 2018 using the full retrospective method. The new guidance requires recognition of a sale of real estate and resulting gain or loss when control transfers and the buyer has the ability to direct use of, or obtain substantially all of the remaining benefit from, the asset (which generally will occur on the closing date); the factor of continuing involvement is no longer a specific consideration for the timing of recognition. The new guidance eliminates the need to consider adequacy of buyer investment, which was replaced by additional judgments regarding collectability and intent and/or ability to pay. The new guidance also requires an entity to derecognize nonfinancial assets and in-substance nonfinancial assets once it transfers control of such assets. When an entity transfers its controlling interest in a nonfinancial asset but retains a noncontrolling ownership interest, the entity is required to measure any non-controlling interest it receives or retains at fair value and recognize a full gain or loss on the transaction; as a result, sales and partial sales of real estate assets are now subject to the same derecognition model as all other nonfinancial assets. We had a transaction in July 2016 accounted for as a partial sale under the previous guidance that meets the criteria for immediate full gain recognition under the new guidance; as a result, we retrospectively recognized an additional $18 million in income in 2016 that was being amortized into income in subsequent periods under the previous guidance. The recognition pattern for our other sales of real estate were not changed by this new guidance. The full retrospective method requires adjustment of each reporting period presented at the time of adoption.






17



The tables below set forth the impact of the adoption of this guidance for amounts previously reported on the consolidated financial statements of COPT and subsidiaries (in thousands):
 
 
As of December 31, 2017
 
As of March 31, 2017
 
As of December 31, 2016
Consolidated Balance Sheets
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
Investment in unconsolidated real estate joint venture
 
$
25,066

 
$
16,721

 
$
41,787

 
$
25,417

 
$
17,765

 
$
43,182

 
$
25,548

 
$
18,113

 
$
43,661

Cumulative distributions in excess of net income
 
$
(818,190
)
 
$
16,105

 
$
(802,085
)
 
$
(774,445
)
 
$
17,115

 
$
(757,330
)
 
$
(765,276
)
 
$
17,451

 
$
(747,825
)
Noncontrolling interests in subsidiaries
 
$
65,549

 
$
616

 
$
66,165

 
$
66,820

 
$
650

 
$
67,470

 
$
71,605

 
$
662

 
$
72,267

 
 
For the Three Months Ended March 31, 2017
Consolidated Statements of Operations and Comprehensive Income
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
Equity in income of unconsolidated entities
 
$
725

 
$
(348
)
 
$
377

Income before gain on sales of real estate
 
$
18,850

 
$
(348
)
 
$
18,502

Net income
 
$
23,088

 
$
(348
)
 
$
22,740

Net income attributable to noncontrolling interests - Common units in COPLP
 
$
(634
)
 
$
12

 
$
(622
)
Net income attributable to COPT
 
$
21,355

 
$
(336
)
 
$
21,019

Net income attributable to COPT common shareholders
 
$
18,175

 
$
(336
)
 
$
17,839

Comprehensive income
 
$
24,496

 
$
(348
)
 
$
24,148

Comprehensive income attributable to COPT
 
$
22,716

 
$
(336
)
 
$
22,380

 
 
 
 
 
 
 
The tables below set forth the impact of the adoption of this guidance for amounts previously reported on the consolidated financial statements of COPLP and subsidiaries (in thousands):
 
 
As of December 31, 2017
 
As of March 31, 2017
 
As of December 31, 2016
Consolidated Balance Sheets
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
Investment in unconsolid. real estate joint venture
 
$
25,066

 
$
16,721

 
$
41,787

 
$
25,417

 
$
17,765

 
$
43,182

 
$
25,548

 
$
18,113

 
$
43,661

Common units
 
$
1,428,301

 
$
16,721

 
$
1,445,022

 
$
1,409,632

 
$
17,765

 
$
1,427,397

 
$
1,401,597

 
$
18,113

 
$
1,419,710

 
 
For the Three Months Ended March 31, 2017
Consolidated Statements of Operations and Comprehensive Income
 
As Previously Reported
 
Impact of Adoption
 
As
Adjusted
Equity in income of unconsolidated entities
 
$
725

 
$
(348
)
 
$
377

Income before gain on sales of real estate
 
$
18,850

 
$
(348
)
 
$
18,502

Net income
 
$
23,088

 
$
(348
)
 
$
22,740

Net income attributable to COPLP
 
$
22,154

 
$
(348
)
 
$
21,806

Net income attributable to COPLP common unitholders
 
$
18,809

 
$
(348
)
 
$
18,461

Comprehensive income
 
$
24,496

 
$
(348
)
 
$
24,148

Comprehensive income attributable to COPLP
 
$
23,562

 
$
(348
)
 
$
23,214

 
 
 
 
 
 
 
Adoption of this guidance had no impact to cash provided by or used in operating, financing or investing activities on our consolidated statements of cash flows for the three months ended March 31, 2017.

18



We early adopted guidance issued by the FASB effective January 1, 2018 that makes targeted improvements to hedge accounting. This new guidance simplifies the application of hedge accounting and better aligns financial reporting for hedging activities with companies’ economic objectives in undertaking those activities. Under the new guidance, all changes in the fair value of highly effective cash flow hedges will be recorded in other comprehensive income instead of income. The new guidance also eases the administrative burden of hedge documentation requirements and assessing hedge effectiveness. We adopted this guidance using the modified retrospective transition method under which we eliminated $276,000 in previously-recorded cumulative hedge ineffectiveness as of January 1, 2018 by means of a cumulative-effect adjustment to our beginning balance of accumulated other comprehensive income (“AOCI”), with a corresponding adjustment to the beginning balance of: cumulative distributions in excess of net income for COPT and subsidiaries; and common units for COPLP and subsidiaries.

In February 2016, the FASB issued guidance that sets forth principles for the recognition, measurement, presentation and disclosure of leases.  This guidance requires lessees to apply a dual approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase of the leased asset by the lessee. The resulting classification determines whether the lease expense is recognized based on an effective interest method or straight-line basis over the term of the lease. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases. The guidance requires lessors of real estate to account for leases using an approach that is substantially equivalent to existing guidance for sales-type leases, direct financing leases and operating leases.  This guidance is effective for reporting periods beginning January 1, 2019 using a modified retrospective transition approach at the time of adoption. Early adoption is also permitted for this guidance. In addition, the guidance permits lessees and lessors to elect to apply a package of practical expedients that allow them not to reassess upon adoption: the lease classification for any expired or existing leases; their deferred recognition of incremental direct costs of leasing for any expired or existing leases; and whether any expired or existing contracts are, or contain, leases. While we are still completing our assessment of the impact of this guidance, below is a summary of the anticipated primary effects of this guidance on our accounting and reporting.

Real estate leases in which we are the lessor:
Balance sheet reporting: We believe that we will apply an approach under the new guidance that is similar to the current accounting for operating leases, in which we will continue to recognize the underlying leased asset as property on our balance sheet.
Deferral of non-incremental lease costs: Under the new lease guidance, we will no longer be able to defer the recognition of non-incremental costs in connection with new or extended tenant leases (refer to amounts reported in our 2017 Annual Report on Form 10-K for amounts deferred in 2017, 2016 and 2015). Upon adoption of the new guidance, we would expense previously deferred non-incremental lease costs for existing leases unless we elect the package of practical expedients, in which case such costs would remain deferred and amortized over the remaining lease terms.
Lease revenue reporting: Under the issued and approved guidance, we believed that the new revenue standard would apply to executory costs and other components of revenue deemed to be non-lease components (such as common area maintenance and provision of utilities), in which case we would need: to separate the lease components of revenue due under leases from the non-lease components; and recognize revenue on the non-lease components as the related services are delivered, which could result in a change to our revenue recognition pattern. However, in March 2018, the FASB tentatively approved a practical expedient to provide lessors with an option to not separate lease components of revenue from non-lease components if: the timing and pattern of transfer of these components is the same as the related lease; and the lease would continue to be classified as an operating lease;
Leases in which we are the lessee:
Our most significant leases as lessee are ground leases; as of March 31, 2018, our future minimum rental payments under these leases totaled $89.7 million, with various expiration dates extending to the year 2100. While we are still in the process of evaluating these leases under the new guidance, we believe that we will be required to recognize right-of-use assets and lease liabilities for the present value of these minimum lease payments. We also believe that these types of leases most likely would be classified as finance leases under the new guidance, which would result in the interest component of each lease payment being recorded as interest expense and the right-of-use asset being amortized into expense using the straight-line method over the life of the lease; however, we expect to elect to apply the package of practical expedients under which we would continue to account for our existing ground leases as operating leases upon adoption of the guidance.

In June 2016, the FASB issued guidance that changes how entities measure credit losses for most financial assets and certain other instruments that are not measured at fair value through net income. The guidance replaces the current incurred loss model with an expected loss approach, resulting in a more timely recognition of such losses. The guidance will apply to most financial assets measured at amortized cost and certain other instruments, including trade and other receivables, loans,

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held-to-maturity debt securities, net investments in leases, and off-balance-sheet credit exposures (e.g. loan commitments). Under the new guidance, an entity will recognize its estimate of expected credit losses as an allowance, as the guidance requires that financial assets be measured on an amortized cost basis and to be presented at the net amount expected to be collected. The guidance is effective for us beginning January 1, 2020, with early adoption permitted after December 2018. We are currently assessing the financial impact of this guidance on our consolidated financial statements.

3.     Revenue Recognition on Construction Contract and Other Service Revenues

We enter into construction contracts to complete various design and construction services primarily for our United States Government tenants. The revenues and expenses from these services consist primarily of subcontracted costs that are reimbursed to us by our customers along with a fee. These services are an ancillary component of our overall operations, with small operating margins relative to the revenue. We review each contract to determine the performance obligations and allocate the transaction price. We recognize revenue under these contracts as services are performed in an amount that reflects the consideration we expect to receive in exchange for those services. Our performance obligations are satisfied over time as work progresses. Revenue recognition is determined using the input method based on costs incurred as of point in time relative to the total estimated costs at completion to measure progress toward satisfying our performance obligations. We believe incurred costs of work performed best depicts the transfer of control of the services being transferred to the customer.

In determining whether the performance obligations of each construction contract should be accounted for separately versus together, we consider numerous factors that may require significant judgment, including: whether the components contracted are substantially the same with the same pattern of transfer; whether the customer could contract with another party to perform construction based on our design project; and whether the customer can elect not to move forward after the design phase of the contract. Most of our contracts have a single performance obligation as the promise to transfer the services is not separately identifiable from other obligations in the contracts and, therefore, are not distinct. Some contracts have multiple performance obligations, most commonly due to having distinct project phases for design and construction for which our customer is making decisions and managing separately. In these cases, we allocate the transaction price between these performance obligations based on the amounts separately set forth in the contracts for such obligations. Contract modifications, such as change orders, are routine for our construction contracts and are generally determined to be additions to the existing performance obligations because they would have been part of the initial performance obligations if they were identified at the initial contract date.

We have three main types of compensation arrangements for our construction contracts: guaranteed maximum price (“GMP”); firm fixed price (“FFP”); and cost-plus fee.

GMP contracts provide for revenue equal to costs incurred plus a fee equal to a percentage of such costs, up to a maximum contract amount. We generally enter into GMP contracts for projects that are significant in nature based on the size of the project and total fees, and for which the full scope of the project has not been determined as of the contract date. GMP contracts are lower risk to us than FFP contracts since the costs and revenue move proportionately to one another;
FFP contracts provide for revenue equal to a fixed fee. These contracts are typically lower in value and scope relative to GMP contracts, and are generally entered into when the scope of the project is well defined. Typically, we assume more risk with FFP contracts than GMP contracts since the revenue is fixed and we could realize losses or less than expected profits if we incur more costs than originally estimated. However, these types of contracts offer the opportunity for additional profits when we complete the work for less than originally estimated. Determining the estimated total costs for contracts under an FFP compensation arrangement may require significant judgment and has a direct effect on our revenue recognition pattern;
Cost-plus fee contracts provide for revenue equal to costs incurred plus a fee equal to a percentage of such costs but, unlike GMP contracts, do not have a maximum contract amount. We do not frequently enter into cost-plus fee contracts. Similar to GMP contracts, cost-plus fee contracts are low risk to us since the costs and revenue move proportionately to one another.

Construction contract cost estimates are based on various assumptions, such as performance of subcontractors and cost and availability of materials, to project the outcome of future events over the course of the project. We review and update these estimates regularly as a significant change could affect the profitability of our construction contracts. We recognize adjustments in estimated profit on contracts under the cumulative catch-up method as the modification does not create a new performance obligation. Under this method, the impact of the adjustment on profit recorded to date on a contract is recognized in the period the adjustment is identified. Revenue and profit in future periods are recognized using the adjusted estimate. If at any time the estimate of contract profitability indicates an anticipated loss on the contract, we recognize the total loss in the quarter it is identified.


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We disaggregate our construction contract and other service revenues by compensation arrangement and by service type as we believe it best depicts the nature, timing and uncertainty of our revenue. The table below reports construction contract and other service revenues by compensation arrangement (in thousands):
 
For the Three Months Ended March 31,
 
2018
 
2017
Construction contract revenues:
 
 
 
GMP
$
20,486

 
$
6,589

FFP
6,435

 
6,198

Cost-plus fee
58

 
17

Other
219

 
230

 
$
27,198

 
$
13,034


The table below reports construction contract and other service revenues by service type (in thousands):
 
For the Three Months Ended March 31,
 
2018
 
2017
Construction contract revenues:
 
 
 
Construction
$
25,915

 
$
10,091

Design
1,064

 
2,713

Other
219

 
230

 
$
27,198

 
$
13,034


We recognized revenue from performance obligations satisfied (or partially satisfied) in previous periods of $309,000 and $146,000 in three months ended March 31, 2018 and 2017, respectively.

Our timing of revenue recognition for construction contracts generally differs from the timing of invoicing to customers. We recognize such revenue as we satisfy our performance obligations. Payment terms and conditions vary by contract type. Under most of our contracts, we bill customers monthly, as work progresses, in accordance with the contract terms, with payment due in 30 days, although customers occasionally pay in advance of services being provided. We have determined that our contracts generally do not include a significant financing component. The primary purpose of the timing of our invoicing is for convenience, not to receive financing from our customers or to provide customers with financing. Additionally, the timing of transfer of the services is often at the discretion of the customer. We recognized no impairment losses on construction contracts receivable or unbilled construction revenue in the periods set forth herein.

Accounts receivable related to our construction contract services is included in accounts receivable, net on our consolidated balance sheets. The beginning and ending balances of accounts receivable related to our construction contracts were as follows (in thousands):
 
For the Three Months Ended March 31,
 
2018
 
2017
Beginning balance
$
4,577

 
$
4,131

Ending balance
$
4,021

 
$
7,376


Under most of our contracts, we bill customers one month subsequent to revenue recognition, resulting in contract assets representing unbilled construction revenue. Contract assets, which we refer to herein as construction costs in excess of billings, are included in prepaid expenses and other assets, net reported on our consolidated balance sheets. The beginning and ending balances of our contract assets were as follows (in thousands):
 
For the Three Months Ended March 31,
 
2018
 
2017
Beginning balance
$
4,884

 
$
10,350

Ending balance
$
4,250

 
$
4,451


Our contract liabilities consist of advance payments from our customers or billings in excess of construction contract revenue recognized. Contract liabilities are included in other liabilities reported on our consolidated balance sheets. Changes in contract liabilities were as follows (in thousands):

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For the Three Months Ended March 31,
 
2018
 
2017
Beginning balance
$
27,402

 
$
32,650

Ending balance
$
8,279

 
$
40,485

Revenue recognized included in beginning balance
$
19,297

 
$
4,199


The change in the contract liabilities balance reported above for the three months ended March 31, 2018 was due primarily to our satisfaction of performance obligations during the period on a contract on which we previously received advance payments from a customer.

Revenue allocated to the remaining performance obligations under existing contracts as of March 31, 2018 that will be recognized as revenue in future periods was $23.5 million, all of which we expect to recognize during the remainder of 2018.

We have no deferred incremental costs incurred to obtain or fulfill our construction contracts or other service revenues.

4.     Fair Value Measurements

Recurring Fair Value Measurements

COPT has a non-qualified elective deferred compensation plan for Trustees and certain members of our management team that permits participants to defer up to 100% of their compensation on a pre-tax basis and receive a tax-deferred return on such deferrals. The assets held in the plan (comprised primarily of mutual funds and equity securities) and the corresponding liability to the participants are measured at fair value on a recurring basis on COPT’s consolidated balance sheets using quoted market prices, as are other marketable securities that we hold. The balance of the plan, which was fully funded, totaled $4.5 million as of March 31, 2018, and is included in the accompanying COPT consolidated balance sheets in the line entitled “prepaid expenses and other assets, net”. The offsetting liability associated with the plan is adjusted to fair value at the end of each accounting period based on the fair value of the plan assets and reported in other liabilities on COPT’s consolidated balance sheets. The assets of the plan are classified in Level 1 of the fair value hierarchy, while the offsetting liability is classified in Level 2 of the fair value hierarchy.

The fair values of our interest rate derivatives are determined using widely accepted valuation techniques, including a discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate market data and implied volatilities in such interest rates. While we determined that the majority of the inputs used to value our derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with our interest rate derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default. However, as of March 31, 2018, we assessed the significance of the impact of the credit valuation adjustments on the overall valuation of our derivatives and determined that these adjustments are not significant. As a result, we determined that our interest rate derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.

The carrying values of cash and cash equivalents, restricted cash, accounts receivable, other assets (excluding investing receivables) and accounts payable and accrued expenses are reasonable estimates of their fair values because of the short maturities of these instruments.  As discussed in Note 7, we estimated the fair values of our investing receivables based on the discounted estimated future cash flows of the loans (categorized within Level 3 of the fair value hierarchy); the discount rates used approximate current market rates for loans with similar maturities and credit quality, and the estimated cash payments include scheduled principal and interest payments.  For our disclosure of debt fair values in Note 9, we estimated the fair value of our unsecured senior notes based on quoted market rates for publicly-traded debt (categorized within Level 2 of the fair value hierarchy) and estimated the fair value of our other debt based on the discounted estimated future cash payments to be made on such debt (categorized within Level 3 of the fair value hierarchy); the discount rates used approximate current market rates for loans, or groups of loans, with similar maturities and credit quality, and the estimated future payments include scheduled principal and interest payments.  Fair value estimates are made as of a specific point in time, are subjective in nature and involve uncertainties and matters of significant judgment.  Settlement at such fair value amounts may not be possible and may not be a prudent management decision